Don’t Overplay the Decoupling Story

By Alen Mattich

Someone once said that if you see a question in the headline or the lead paragraph of an article, the answer is “no.” It holds here, too.

But maybe the decoupling theme doesn’t stretch right across emerging markets. What if we were to remove the bits that are too heavily linked to local developed markets or have their own idiosyncratic problems.

AFP/Getty Images

Poland has weathered the credit crunch well. Young Polish rest and play on a beach on the Vistula river bank in Warsaw.

For instance, how about we ignore Europe’s emerging markets: the former communist Eastern block countries? Although a few, like Poland, have had a good credit crunch, others, particularly the Baltic states, have been disaster zones. And the likes of Hungary are mirror images of Greece. What’s more, even setting aside their domestic issues, the crisis affecting the euro zone is bound to infect the rest of the region, be it through austerity-driven drops in trade or, ultimately, a domino cascade of sovereign defaults.

And let’s also exclude sub-Saharan Africa. Although the region has been benefiting from booming commodities and direct Chinese involvement, thanks to its hunger for those same commodities, there is little to suggest its historic problem of volatile politics has gone away.

In other words, limit the discussion to South America, the Pacific rim and subcontinental Asia.

After all, these blocs, anchored by the BIC giants — Brazil, India and China; the famous BRICs less Russia, which is an oil-dependent kleptocracy and should be excluded from any sensible discussion about investment — are what most people mean when they talk about emerging markets these days.

And they certainly look good. Brazil is forecast to post real GDP growth of 5.5% this year, while China’s is seen at 10% and India’s at 8.8%. Indeed, these countries are doing so well that they’re overheating, as is evident in climbing inflation rates — 5.1% this year for Brazil, 3.1% for China and 13.1% for India, a rise of three percentage points or more over the past year for the latter two.

By contrast, the G-7 group of advanced economies will be struggling along with growth of 2.3% this year and a subdued 1.4% inflation rate, according to IMF estimates. And they won’t see much better for years to come.

In just about every major macro investment thesis, strategists are arguing about how the developing world will continue to outperform over the years to come. Not only are these countries playing catch-up with mature economies, often from a low base, but they have considerable scope to expand domestic demand and therefore are not dependent on exports to the West, while they also tend to have healthier private-sector debt positions. They tend to be large international creditors, with strong government finances and low private-sector debt loads, particularly compared with the Anglo-Saxon economies.

So what’s to doubt?

To begin with, there’s the small matter of history. Emerging markets, with some notable exceptions like South Korea and Taiwan, have for many decades been a graveyard for hopeful but ill-informed foreign investors. Just since 1980 we’ve had the Mexico crisis, the Russia crisis, the Argentina crisis and the Asia crisis, not to mention a couple of spectacular wipeouts in China.

Ferocious gains have tended to be followed by even more brutal losses.

To be sure, it could be different this time.

But investors ought to be concerned about some of the apparent strengths these economies show. For instance, China’s trade surplus as a percentage of global GDP exceeds even those of Japan in the 1980s and the U.S. in the 1920s, on the base of a much smaller domestic economy. Both of the latter cases were followed by enormous market busts and consequent destruction of huge swathes of malinvested capital. The odds must favor China following suit in the not too distant future.

There are considerable macroeconomic risks beyond just standard measures of government fiscal policy, argued former IMF chief economist and MIT professor Simon Johnson recently on his Baseline Scenario blog. What’s more, private-sector problems typically got these economies into trouble in the past, not public-sector debt. What’s more, the strength of domestic asset prices in these countries is likely to be encouraging considerable borrowing. To be sure, these countries still have very underdeveloped consumer debt markets, and thus not a lot of household debt, but their corporate and banking sectors are another story. Just consider China’s real-estate bubble.

Should the developed world suffer another leg down in the post-credit crunch restructuring of its overleveraged economies, it would be too much to think emerging economies won’t also suffer. After all, strong correlations on the way up also suggest strong correlations on the way down as well.

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